Pathways to private equity

Popular with institutional investors and virtually unknown to private investors, private equity can provide an alternative to listed markets.

Most private clients are not like institutional investors who are wholly focused on managing their portfolio. Picture: Sam Mooy

Private equity investments continue to be prominent in the portfolios of some of the world’s most sophisticated investors, including sovereign wealth funds.

If we look at the most recent report from the Future Fund, 15 per cent of the total investment portfolio is now in private equity. But what is this asset class and why has it been so difficult to access it?

Increases in private equity allocations have been quite consistent in recent years, fuelled by two forces: First, the well-cited persistent outperformance (of private) over public equities, and second, a significantly larger investment universe, and thus diversification opportunity.

Despite the benefits of investing in private equity, access can be a challenge for private clients. Private equity managers typically require sizeable minimum investment levels, which can force investors to carry too much portfolio concentration in terms of investment geography, sector and financing stage.

Investing in private markets broadly is more nuanced than public market investing.

If you have a favourable view on Amazon or Apple, you can simply buy shares on market. To buy a private company however, takes time — private opportunities need to be sourced, due diligence carried out, then structured and funded, typically with both equity and debt.

As a result of this dynamic, private market investment vehicles are structured with drawdown models where fund managers call capital only when needed, as opposed to taking full payment of investors’ commitments upfront, as is the case when buying a (listed) global equity fund.

Moreover, the difference in performance between the best, median and worst performing managers is significantly wider, meaning that picking the wrong manager in private equity is likely to have a far greater impact on returns than for public equity (fund) equivalents.

Separately, an investor has to consider fees and liquidity. Fees are perhaps a subject for another time but liquidity however, is critical to this specific conversation.

Private equity fund terms are often stated at 10+ years with multiple extension options. In reality, the cash weighted life of a private equity fund is normally far less and when netting capital calls and return distributions, investors typically never reach 100% exposure to private equity during the life of the fund.

Simply put, a 10-year fund does not mean that an investor pays $100 upfront and only receives that sum plus profits in 10 years-in many cases, investors may not even reach $50 out of pocket cash given early distributions that can fund capital calls, leaving themselves under-invested.

What is needed to address this (among the other challenges noted) is the ability for private clients to allocate into a vehicle frequently and over a reasonable period of time (as opposed to a single closing date), and preferably into a portfolio that is already invested and diversified, much like any traditional asset class portfolio.

This inbound liquidity is important as it enables private clients to allocate when it suits them and at the optimum time for their portfolio, as opposed to patiently holding cash awaiting deployment.

Most private clients are not like institutional investors who are wholly focused on managing their portfolio. As such, they should not be held captive to a given manager’s fundraising cycle.

Ultimately, private equity and private markets more broadly need to evolve to facilitate a different style of investor.

As this happens, we expect to see institutional products translate into private client solutions.

Martin Randall is a senior investment specialist-Alternatives at Crestone Wealth Management